Three months ago, the global outlook was in many ways more clear. The global economy was recuperating at a fast pace, albeit from a very low level, key indicators surprised on the upside and our expectation of a V-shaped recovery was overall being confirmed. Equity prices rose sharply, commodity prices climbed back toward levels that made sense from an economic point of view and the pro-cyclical, high-beta, currencies that were sold off when risk aversion dominated saw remarkable bounce-backs.

In late summer and autumn, however, things have not been so straightforward; economic data has been mixed, the sustainability of the economic recovery has been questioned and most central banks have been reluctant to buy into the improvement in economic and financial conditions and have instead kept the bias an ‘emergency setting’ of monetary policy. This has helped to keep yields on government bonds low.

We expect the following three themes to take centre stage on a 12-month horizon:

  • Strong economic performance and positive earnings surprises. Compared with consensus forecast we still have a very positive view on the economic outlook. Most importantly we look for a stabilisation of inventories at current, relatively low, levels to be a strong boost to global GDP growth. A total contribution of 1-2 percentage points to annualised quarterly growth is expected to be seen from Q3 09-Q1 10. We expect the strength of company earnings to continue to surprise the market and likely drive stocks higher. Commodity prices are likely to follow. Implications: from a pure cyclical perspective AUD, NZD, CAD, SEK and NOK are the most obvious beneficiaries of this – USD and JPY are the likely losers.
  • The unsynchronised central bank hiking cycle. Relative interest rates have not been a key driver of the currency market during 2009, as global policy rates converged at a very low level. We look for relative rates to gain importance, but the timing of exit strategies is likely to be asynchronous. We see three groups of central banks: i) First movers: Australia has already hiked rates, Norway is expected to follow this month, and a Canadian rate hike has moved closer after surprisingly good activity data; ii) Followers: Euroland, UK, New Zealand and Sweden could all see tighter monetary policy by mid-2010. While a policy tightening in the UK may appear distant after the recent very dovish BoE remarks, high inflation through 2010 suggests that rate hikes on a six-month horizon cannot be ruled out. In Sweden, rate hikes are likely to be delivered in heavy doses when they finally arrive. In Euroland, great uncertainty about timing remains, but we continue to look for the ECB to hike rates prior to the Fed; iii) Laggards: The US and Japan are not likely to see a tightening of monetary policy before late 2010 at the earliest – however, once hikes are priced in we could face a very steep US curve. Implications: AUD, NZD, CAD (and potentially NOK) should move well into overvalued territory, GBP and SEK has the potential to surprise on the upside, while USD and JPY should see further pressure. However, as we expect to see a rather steep US money market curve by the end of our forecast horizon this should contribute to lower EUR/USD levels from mid-2010.
  • The ‘known unknowns’ - A change in FX drivers, reserve diversification and exchange rate misalignments. These are all themes difficult to measure and quantify but likely to affect currencies throughout 2010.

    We are already seeing that the strong link between currencies and risk is fading, albeit from a high level. We expect this trend to evolve further as the global recovery matures, global equities will trade less with a clear direction, and a divergence in monetary policy materialises. Going into 2010 this should pose an end to the ‘bizarre’ market dynamics that has dominated since New Year where e.g. better-than-projected US macro data has tended to weaken the dollar.

    The dollar is the world’s preferred reserve currency for many reasons: The US economy is the world’s largest, around 70% of global trading is in dollars, the US dollar is the world’s most liquid and widely accepted currency, not least because central banks have chosen it to be that way. The dollar’s status as the favoured reserve currency makes it easier for the US to run a high current account deficit with greatly postponed economic impact. China, Russia and Iran have, however, recently intensified their arguments for an alternative to the dollar. And in September, the UN conference on Trade and Development issued a report that blamed the “dominance of the dollar” for playing a dominant role in the recent build-up of global imbalances. In the event that non-United States holders of dollar-denominated assets decided to shift holdings away from the dollar, there could be serious consequences for the US economy. We account for the heightened risk premium on the dollar in our forecast by allowing for a sustained divergence from long-term fair value.

    We are beginning to have serious misalignments from long-term equilibriums (such as PPP-estimates) established. AUD, NZD, EUR and CAD belong to the overvalued camp while SEK, GBP and USD belong to the undervalued. We see a good chance that the former group can deviate even farther from equilibriums over the coming quarters while we do not expect the already cheap SEK and GBP to fall further. The USD has previously been even cheaper and if for example the dollar’s reserve status comes further under pressure we have serious doubts on whether we ever will see a return to EUR/USD’s presumed fair value of 1.25.